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Tricky Shortcuts

When regulators in 2004 went after Fannie Mae for failing to adhere to requirements of FAS 133, much of Corporate America considered itself on the spot as well: Five years after the adoption of the accounting standard that determines how U.S. companies report hedging activities, here was a high-profile derivative user being nailed for what had become a relatively common interpretation of the rule. How many others would be tripped up by 133? In fact, another 230 companies or so--including high-profile names such as Ford Motor Co. and Bank of America Corp.--have faced similar challenges. All of this made companies pause, and even backtrack a bit. But it was not until January when behemoth General Electric Co., with its best-practices treasury, fell victim to 133 that the potential scale of Corporate America's problems was brought home. "For a lot of people, it was a case of, if a company as savvy and sophisticated as GE--the originator of Six Sigma--is getting this wrong, then is everyone below GE also getting it wrong?" suggests Jiro Okochi, CEO of derivatives risk management software firm Reval.com Inc. "I think it was a bit of an eye-opener."

GE was forced to restate five years worth of reported earnings, starting with its 2001 financials, resulting in a reduction of $343 million. The company's transgression? When using interest rate swaps to fix the rates on its vast commercial paper (CP) program, GE had failed to specify which swaps applied to which CP issues.

The so-called "specificity requirement" on which GE ran aground, is just one of 133's many provisions. (The rules themselves, along with subsequently issued guidance, run to well over 1,000 pages.) But it's hardly the most controversial. That honor undoubtedly belongs to the shortcut rule, which provides users of interest rate swaps with a quicker way to comply with the standard. Misinterpretation of the shortcut's qualifying criteria was the downfall for Fannie Mae and many others. The question is: Why are so many U.S. companies still getting it wrong on FAS 133 after so many years and after so much attention has been paid to the standard?

First, even staff at the Financial Accounting Standards Board, the U.S. rulemaking body on accounting, admit that the complexity of the rule leaves it open to interpretation. "It's a very long document, and it has a lot of provisions in it that people don't all read alike," says Ron Lott, FASB senior technical adviser and one of the original authors of 133. "I honestly believe that, at times, people make it more complicated than it needs to be, but it's already plenty complicated."
Executives would claim--privately of course--that a bigger problem is that FASB keeps "changing" the rules--or at least the interpretation of the rules. The latest example--and one that could cause a tectonic shift in the way companies account for their derivatives use--is a debate currently being waged internally within FASB over whether foreign exchange and commodities hedges have their own equivalent of the shortcut method, known as "critical terms matching." The relevant paragraph of the standard is one of two currently being reviewed by FASB's board and is a cornerstone of hedge accounting practice in the U.S., according to Robert Richardson, managing director and co-founder of FXpress Corp: "Critical terms matching has been very widely used by U.S. corporates for foreign exchange hedges, particularly if a company uses simple forwards to hedge to the exact date of the exposure."

Despite this, FASB's Lott, who authored the paragraph himself when the rule was being drawn up in the late 1990s, says that his intention was never to create a forex equivalent of the shortcut. The paragraph makes a reference to "matching terms" in forex hedges, he says. "But what I had in mind when talking about matched terms was not a separate method. All we were trying to say was 'look, if you get your derivatives and the terms are the same as the thing you're trying to hedge, then it's not very difficult to get effectiveness.' It was just an observation [about forex]."

Now, FASB's board will decide whether to stick with Lott's interpretation, or to bow to market convention. Lott says he "can't predict the outcome" of the project, but he acknowledges that, when the issue was discussed at a January 31 board meeting, there was at least one FASB board member who believed that the standard should allow the FX shortcut.

Many companies will be fervently hoping that Lott's original intentions are not upheld by FASB. "To date, the accounting rules have not been an obstacle to us managing financial risk in a way that we think makes sense for us as a company," says one dismayed assistant treasurer at a Fortune 100 technology company, who asked to remain anonymous. "But if these challenges are upheld, it would make it more difficult for us to manage risk in the way we currently do. If these changes go through, they're not going to lead to better financial reporting by U.S. companies. All that will happen is a further reduction in the efficiency of U.S. business and an increase in the cost of being a public company in this country."
The fundamental problem, says Reval's Okochi, is that both the shortcut and the critical terms match method apply to basic hedging techniques. "This isn't a rule that relates to some rarely used, exotic product. It relates to basic, plain vanilla hedging. Changing the way the shortcut was implemented had a wide impact on interest rate hedgers. Changing critical terms matching would have an even wider impact on foreign exchange and commodities," he says.

So is it time to sound the death knell for shortcut hedge accounting on both the interest rate and FX side? In fact, a safe path through this section of the standard appears so uncertain that many auditors are now advising companies to stop using it altogether, says FXpress Corp's Richardson: "Most of the auditors that we've been in contact with are insisting that their clients use long-haul testing instead."

Some treasury executives aren't waiting for advice from their auditors. Instead, they're beginning to seek out another, more balanced approach to the issue--one which considers the accounting treatment, but does so as just one of a range of inputs to the overall hedging policy. "Hedging and hedge accounting should be viewed as related, but somewhat independent, decisions," says Fred Schacknies, North America treasury director at the newly merged Alcatel-Lucent's U.S. headquarters in Murray Hill, N.J. "Although both involve trade-offs of risk and reward, you can identify an optimal position after thorough analysis."

When the company first faced the apparent need to implement hedge accounting, Schacknies launched an analysis of how Lucent Technologies Inc.'s risk profile and reported earnings would have changed under various hedge accounting scenarios. "We found that the accounting treatment would not have had a material impact--and was unlikely to have one in the future," he says.

The team--under North American treasurer Denise McGlone--then began applying a similarly hard-nosed, rigorous approach to the hedging policy as a whole. This kind of process has to begin with a clear statement of the hedging policy's aim, says McGlone: "Are you trying to reduce the volatility of cash flows, the volatility of earnings? What level of FX visibility is required? Corporate level or all the way to the project level? How important is efficiency and the costs of infrastructure required to support the hedging program?"

From that starting point, companies can go on to identify the various components that influence the success of the policy's aims: At its simplest, this might mean assessing the risk reduction achieved by a single option trade. But the net has to be cast much wider, says Schacknies: "Traditional decision frameworks tend to focus on the net exposure achieved after hedging at a transactional level. A holistic corporate approach should look at the incremental effects of those decisions for the corporate in terms of both cash and earnings."
In other words, companies should be looking not just at the risk reduction achieved by a hedge, but at the cost of putting that hedge on--and, more importantly, at how those decisions stack up across the entire enterprise. Companies who do this could find a pleasing outcome, he says: Achieving the most cost-effective reduction of risk might not involve hedging as much as they think. It also might mean not worrying about FAS 133 quite as much as they currently do. "The job of the strategic treasurer is to manage risk to tolerable levels in the most cost-effective manner possible," says McGlone. "It's not about eliminating all risk at any price. It's about getting the biggest risk reduction, the biggest bang from every dollar you spend."

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